Thursday, April 22, 2010

The Fed's Balance Sheet

The Fed released its financial statements for 2009 yesterday, with a New York Times business section story here. The transfer from the Fed to the Treasury increased 50% over 2008. One might think that the dramatic interventions by the Fed would surely have caused losses for the central bank, but obviously that is not so. We might then be led to the conclusion that the Fed's interventions were justified - if the Fed can make a profit, it must be doing something right. Of course we don't want to be too sanguine about it, as the Fed is in part just exploiting its monopoly power to issue outside money.

In the New York Times piece, there is a quote from Vincent Reinhart, formerly at the Fed, who says

“The Fed can only play this game as long as the public is willing to hold its liabilities,” said Mr. Reinhart, now a scholar at the American Enterprise Institute, a conservative research organization. “If it tried to increase its balance sheet tenfold, say, the public would be unwilling to hold those reserves. You’d get dollar depreciation and inflation.”

Wrong. As I discussed here, the Fed can successfully induce the banking system to hold large quantities of reserves by setting the interest rate on reserves appropriately, with no inflationary consequences. Indeed, if the Fed wanted to, it could fully exploit its monopoly power and take over most of the financial intermediation activity in the United States, set the interest rate on reserves appropriately to get the banks to hold the reserves and not generate any inflation, due to the fact that the price level can essentially be viewed as being determined by the supply and demand for currency. We would not like the result much, of course, as the Fed is not likely to be a very good banker, and it would be determining all the details of how credit is allocated in the US economy. Indeed, I don't like what we have already, which is a situation where the Fed is subsidizing the housing market for, I think, no good reason.

6 comments:

I would add that as long as the Fed only issues $100 to people who offer $100 of bonds in exchange, the Fed is always in a position to use its bonds to buy back all the dollars it has issued. Compare that to the case where the Fed simply helicopter drops dollars. The Fed is then incapable of buying back its dollars.

The helicopter drop is inflationary. The open market purchase of bonds is not.

That's interesting. You sound like you might subscribe to what I call the backing theory of money, which holds that money is valued on the same principles as any other liability. If so, welcome to the (very small) club!

I wonder if you'd also agree that there is no such thing as fiat money, in the sense that all money is actually backed by the assets of its issuer.

Yes, I learned about the backing theory of money when Sargent and Wallace were thinking about it in the early 80s. Fiat money is a theoretical construct. In practice, the outside money issued by the Fed is not that thing at all, but could be under a particular operating rule.

That would put you at odds with Scott Sumner, Nick Rowe, Bill Woolsey, etc., who all claim the dollar is fiat money. Nick was the most explicit about it, in his "Why Do Central Banks Have Assets?", where he denied that assets matter.

My theoretical construct says that fiat money would create a free lunch for its issuer, which attracts rival moneys, which would reduce the value of the so-called fiat money to zero. The fiat money just can't get off the ground.

I think of it this way: A landowner collects rent in silver. He buys groceries by issuing silver IOU's, which he accepts for rent. His IOU's circulate as money, even though he never pays actual silver for them. He can then designate his kitchen as his central bank. His bank issues more silver IOU's, and uses them to buy bonds that he himself issued sometime earlier. All this does is replace one of his liabilities (bonds) with another (silver IOU's). Sounds like a good description of the US dollar to me, and there's no need for this implausible stuff called fiat money.

Here's my take on it. Just think of the central bank as another financial intermediary, except we give it a monopoly on the issue of particular kinds of circulating liabilities (the monopoly is explicit in most countries, but not in the US). Those liabilities are not explicit promises to future payoffs, but they are typically (i.e. not right now) backed by obligations of the the fiscal arm of the government. Thus, depending on the commitments of the government to its central bank, outside money is backed by the power of the government to tax.